LEARNING OBJECTIVES

• Describe the difference between accounting value (or

book value) and market value.
• Describe the difference between accounting income and
cash flow.
• Describe the difference between average and marginal
CHAPTER 2 tax rates.
F I N A N C I A L S TAT E M E N T S , TA X E S , A N D C A S H F L O W • Determine a firm’s cash flow from its financial
statements.

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CHAPTER OUTLINE THE BALANCE SHEET 1

• The Balance Sheet. The balance sheet is a financial statement showing a firm’s accounting value
on a particular date.
• The Income Statement. • Organizes and summarizes what a firm owns (assets), what a firm owes
(liabilities), and the difference between the two (equity).
• Taxes.
Assets are classified as either current or fixed:
• Cash Flow. • A fixed asset is one that has a relatively long life.
• May be tangible (for example, truck or computer) or intangible (for example, trademark).
• A current asset has a life of less than one year (for example, inventory, cash,
accounts receivable).
Liabilities are the first thing listed on the right side of the balance sheet and
are classified are either current or long-term.
• Current liabilities have a life of less than one year, while long-term liabilities are
debts not due in the coming year.
• Assets = Liabilities + Stockholders’ Equity.
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 THE BALANCE SHEET 2 THE BALANCE SHEET 3

The balance sheet is a financial statement showing a firm’s accounting value Shareholders equity (that is, common equity or owners’ equity)
on a particular date. is the difference between the total value of the assets (current
• Organizes and summarizes what a firm owns (assets), what a firm owes and fixed) and the total value of the liabilities (current and long-
(liabilities), and the difference between the two (equity).
term).
Assets are classified as either current or fixed:
Balance sheet “balances” because the value of the left side
• A fixed asset is one that has a relatively long life.
always equals the value of the right side.
• May be tangible (for example, truck or computer) or intangible (for example, patent).
• A current asset has a life of less than one year (for example, inventory, cash, • Value of firm’s assets is equal to the sum of its liabilities and
accounts receivable). shareholders’ equity.
Liabilities are the first thing listed on the right side of the balance sheet and
are classified are either current or long-term. Balance sheet identity, or equation, must hold:
• Current liabilities have a life of less than one year (for example, accounts payable).
• Long-term liabilities are debts not due in the coming year (for example, a loan the Assets = Liabilities + Shareholders’ equity
firm will pay off in five years).
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CONSTRUCTION OF THE BALANCE SHEET NET WORKING CAPITAL

Net working capital is the difference between a firm’s current
assets and its current liabilities.
• Positive when cash that will become available over the next 12
months (that is, current assets) exceeds cash that must be paid
over the same period (that is, current liabilities).
• Usually positive in a healthy firm.

Three particularly important things to keep in mind when

examining a balance sheet:
1. Liquidity.
2. Debt versus equity.
3. Market value versus book value.
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 U.S. CORPORATION 2020 AND 2021
LIQUIDITY AND DEBT VERSUS EQUITY
BALANCE SHEETS
Liquidity refers to the speed and ease with which an asset can be converted U.S. CORPORATION
2020 and 2021 Balance Sheets (in $ millions)
to cash.
• Two dimensions are ease of conversion versus loss of value. Assets Liabilities and owners’ Equity
2020 2021 2020 2021
• Highly liquid asset is one that can be quickly sold without significant loss of value, while
Current assets Current liabilities
an illiquid asset is one that cannot be quickly converted to cash without a substantial
price reduction. Cash $ 104 $ 221 Accounts payable $ 232 $ 266
Accounts receivable 455 688 Notes payable 196 123
• Assets are normally listed on the balance sheet in order of decreasing liquidity,
Inventory 553 555 Total $ 428 $ 389
with current assets being relatively liquid and fixed assets being relatively illiquid.
Total $1,112 $1,464
• The more liquid a business, the less likely it is to experience financial distress. Fixed assets
Net plant and $1,644 $1,709 Long-term debt $ 408 $ 454
equipment
If a firm borrows money, it usually gives first claim to the firm’s cash flow to Owners’ equity
creditors, with equity holders entitled to only the residual value. Common stock and paid-in surplus $ 600 $ 640

• Use of debt in firm’s capital structure is called financial leverage. Retained earnings 1,320 1,690
Total $1,920 $2,330
Total assets $2,756 $3,173 Total liabilities and owners’ equity $2,756 $3,173

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MARKET VALUE VERSUS BOOK VALUE: AN

MARKET VALUE VERSUS BOOK VALUE
EXAMPLE
Values on balance sheet for the firm’s assets are book values The Klingon Corporation has net fixed assets with a book value of $700 and an appraised market
value of about $1,000. Net working capital is $400 on the books, but approximately $600 would
and generally are not what the assets are actually worth. be realized if all the current accounts were liquidated. Klingon has $500 in long-term debt, both
• Under generally accepted accounting principles (GAAP), audited book value and market value. What is the book value of the equity? What is the market value?
We can construct two simplified balance sheets, one in accounting (book value) terms and one
financial statements in the U.S. mostly show assets at historical in economic (market value) terms:
cost (that is, assets are “carried on the book” at what the firm paid
KLINGON CORPORATION
for them, no matter how long ago they were purchased or how Balance Sheets
much they are worth today). Market Value versus Book Value

Assets Liabilities and Shareholders’ Equity

• No necessary connection between total assets shown on the Book Market Book Market
balance sheet and the value of the firm. Net working capital $ 400 $ 600 Long-term debt $ 500 $ 500
Net fixed assets 700 1,000 Shareholders’ equity 600 1,100
For financial managers, accounting value of stock is not $1,100 $1,600 $1,100 $1,600
especially important; it is the market value that matters.
In this example, shareholders’ equity is actually worth almost twice as much as what is shown on
• Market value of an asset depends on things like its riskiness and the books. The distinction between book and market values is important precisely because book
cash flows, neither of which have anything to do with accounting. values can be so different from true economic value.
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 THE INCOME STATEMENT 1 U.S. CORPORATION: INCOME STATEMENT

The income statement is a financial statement summarizing a firm’s U.S. CORPORATION

performance over a period of time, usually a quarter or a year. 2021 Income Statement (in millions)

Income statement equation is: Net sales $1,509

Cost of goods sold 750
Revenues – Expenses = Income Depreciation 65
Earnings before interest and taxes $ 694
First thing reported on income statement would usually be revenue
Interest paid 70
and expenses from the firm’s principal operations.
Taxable income $ 624
• Subsequent parts include, among other things, financing expenses such as Taxes (21%) 131
interest paid.
Net income $ 493
• Taxes are reported separately. Dividends $ 123
• Last item is net income (that is, “the bottom line”). Addition to retained earnings 370

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THE INCOME STATEMENT 2 TAXES

A financial manager should keep three things in mind when looking at an Taxes can be one of the largest cash outflows a firm experiences.
income statement:
1. GAAP. • Size of a company’s tax bill is determined by the tax code, an often
amended set of rules.
• As a result of the way revenues and expenses are realized, income statement figures
may not be representative of actual cash inflows/outflows that occurred during a
particular period. Federal corporate tax rates became a flat 21% after the passage
2. Cash versus noncash items. of the Tax Cuts and Jobs Act of 2017.
• Noncash items are expenses charged against revenues that do not directly affect cash • Tax rates on other forms of business (for example, proprietorships,
flow, such as depreciation.
partnerships, and LLCs) did not become flat.
• Crucial to separate cash flows from noncash accounting entries.

3. Time and costs. Average tax rate is calculated as total taxes paid divided by total
• Product costs include things such as raw materials, direct labor expense, and manufacturing taxable income, while the marginal tax rate is the amount of tax
overhead.
• Period costs are incurred during a particular time period and might be reported as selling,
payable on the next dollar earned.
general, and administrative expenses.
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 PERSONAL TAX RATES AND AN EXAMPLE CASH FLOW
Taxable Income Tax Rate
$ 0 to 9,875 10%
Cash flow means the different between the number of dollars that
9,875 to 40,125 12
came in and the number of dollars that went out.
40,125 to 85,525 22 No standard financial statement presents this information in the way
85,525 to 163,300 24 that we wish.
163,300 to 207,350 32
• Statement of cash flows is a standard financial accounting statement, but
207,350 to 518,400 35 it is concerned with a somewhat different issue.
518,400+ 37
Cash flow identity says the cash flow from the firm’s assets is equal to
Deep in the Heart of Taxes the cash flow paid to suppliers of capital to the firm:
Algernon, a small proprietorship owned by an unmarried individual, has a taxable income of
$80,000. What is its tax bill? What is its average tax rate? Its marginal tax rate? From Table 2.3, we Cash flow from assets = Cash flow to creditors + Cash flow to stockholders
see that the tax rate applied to the first $9,875 is 10 percent; the rate applied to the next $30,250
is 12 percent; and the rate applied after that up to $80,000 is 22 percent. So Algernon must pay. Cash flow identity reflects the fact that a firm generates cash
10 × $9,875 + .12 × $30,250 + .22 × ($80,000 − 40,125) = $13,390. The average tax rate is thus
through its various activities, and that cash is either used to pay
$13,390 / $80, 000  .1674, or 16.74 percent. The marginal rate is 22 percent because
Algernon’s taxes would rise by 22 cents if it had another dollar in taxable income.
creditors or paid out to the owners of the firm.
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CASH FLOW FROM ASSETS 1 CASH FLOW FROM ASSETS 2

Cash flow from assets is the total of cash flow to creditors and cash Operating cash flow is calculated as revenues minus costs and tells us
flow to stockholders, consisting of the following three components: whether a firm’s cash inflows from its business operations are sufficient to
cover its everyday cash outflows.
• Operating cash flow refers to cash generated from a firm’s normal
business activities. • Do not include depreciation or interest in the calculation, but be sure to include
taxes.
• Capital spending refers to the net spending on fixed assets (purchases of
• Negative operating cash flow is a sign of trouble.
fixed assets less sales of fixed assets).
• Different calculation used for operating cash flow in accounting.
• Change in net working capital is measured as the net change in current
assets relative to current liabilities for the period being examined and Net capital spending (that is, CAPEX) is money spent on fixed assets less
represents the amount spend on net working capital. money received from the sale of fixed assets.
Cash flow from assets is sometimes called free cash flow, referring to • Could be negative is the firm sells more assets than it purchases.
the cash the firm is “free” to distribute to creditors and stockholders Change in net working capital is found by taking the difference between the
because it is not needed for working capital or fixed asset investments. beginning and ending net working capital (NWC) figures.
• Often referred to as the “addition to” NWC.
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 CASH FLOW TO CREDITORS AND
CASH FLOW FROM ASSETS 3

STOCKHOLDERS
U.S. CORPORATION Cash flow to creditors is calculated as a firm’s interest payments to creditors less net
new borrowing.
2021 Cash Flow from Assets • Sometimes called cash flow to bondholders.

Operating cash flow $628 U.S. CORPORATION

2021 Cash Flow to Creditors
– Net capital spending 130
Interest paid $70
– Change in NWC 391 – Net new borrowing 46

Cash flow from assets $107 Cash flow to creditors $24

Cash flow to stockholders is calculated as dividends paid out by a firm less net new
equity raised.
U.S. CORPORATION
2021 Cash Flow to Stockholders

Dividends paid $123

– Net new equity raised 40
Cash flow to stockholders $ 83
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CASH FLOW SUMMARY SELECTED CONCEPT QUESTIONS

I. The cash flow identity
• What is liquidity? Why is it important?
Cash flow from assets = Cash flow to creditors (bondholders)
+ Cash flow to stockholders (owners)
• Explain the difference between book value and market value.
II. Cash flow from assets
Cash flow from assets = Operating cash flow
Which is more important to the financial manager? Why?
− Net capital spending
− Change in net working capital (NWC) • What is the income statement equation?
where:
Operating cash flow = Earnings before interest and taxes (EBIT) • What is the difference between a marginal and an average
+ Depreciation − Taxes
Net capital spending = Ending net fixed assets − Beginning net fixed assets tax rate?
+ Depreciation
Change in NWC = Ending NWC − Beginning NWC • What is the cash flow identity? Explain what it says.
III. Cash flow to creditors (bondholders)
Cash flow to creditors = Interest paid − Net new borrowing
• What are the components of operating cash flow?
IV. Cash flow to stockholders (owners)
Cash flow to stockholders = Dividends paid − Net new equity raised

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 END OF CHAPTER
CHAPTER 2

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